After its 43pc gain, Next still offers capital growth potential as the cost of living crisis ends

The company’s risk to reward trade-off is among the most attractive in the retail sector, while debt is low and cash flow is strong

With inflation still standing at twice the Bank of England’s 2pc target, many investors may believe that retailers currently offer scant scope for capital growth. After all, above-target inflation suggests that the cost of living crisis is alive and well.

However, wage growth has outpaced the rate of annual inflation since April last year. Between September and November, for instance, total pay increased by 1.3pc year on year in real terms. This means consumers are enjoying improved spending power, which tallies with an upward trend in consumer confidence over recent months.

Certainly, the implementation of a more restrictive monetary policy over the past two years means higher mortgage payments, as borrowers fix at less attractive rates, and a slow-growing economy that is teetering on the brink of recession.

Both of these factors could weigh on retail stocks over the short run. But with interest rate cuts on the horizon and an unemployment rate of about 4pc still modest by historical standards, the outlook for retailers such as Next is increasingly upbeat.

The FTSE 100 company, which was recommended by this column in November 2020, has produced a capital gain of 43pc and outperformed the wider index by 17 percentage points since that tip. Its latest trading update, released last month, showed that full-price sales rose by 5.7pc in the nine weeks to Dec 30.

This was significantly better than the company’s previous guidance of 2pc growth and prompted an increase in its own expectations for the full year. Next now expects pre-tax profits to rise to £905m in the financial year to January 2024, which is £20m higher than its previous estimate and represents growth of 4pc. In the current financial year, it forecasts that pre-tax profits will rise by 5pc.

While a share price multiple of around 14.5 times forecast earnings suggests that this rate of growth has been more than adequately priced in by investors, Questor expects the company’s shares to deliver further index-beating capital returns. It is well placed to benefit from a resumption in the shift from bricks-and-mortar retailing to online, which has picked up following an initial decline in the immediate aftermath of the pandemic.

Indeed, the proportion of Britain’s retail sales conducted online has risen year-on-year in each of the past seven months. Next’s online sales rose by 9.1pc in the nine weeks to Dec 30, while its in-store sales were just 0.6pc higher than in the same period of the previous year. Its significant and sustained investment in warehousing and logistics appears to be paying off as

‘With solid finances, a strong competitive position and increasingly diverse business model, it is well placed long-term’

the retail sector undergoes continued structural change.

Its strategy of investing in third-party brands could also help earnings growth. While the main Next brand is relatively mature and has a sizeable market share across several categories, other brands in which the group has an ownership interest, such as Reiss, Fatface and Joules, could offer stronger growth prospects as they benefit from the significant investment made by Next in its online infrastructure.

The company’s sound financial position means further investments could be ahead. In the first half of the previous year, net interest costs were covered more than 12 times by operating profits, while the group continues to enjoy strong cash flow. In its latest trading statement, for example, it reported plans to use £275m for either share buybacks or investments in the current financial year. It also earmarked a further £75m for debt repayment this year after it reduced net debt by £100m in the 2024 financial year.

Clearly, several risks could present challenges for the company in the short run. Elevated geopolitical uncertainty in the Middle East may delay or restrict the flow of goods, while the full impact of previous interest rate rises has not yet been felt because of the existence of time lags.

However, with solid finances, a strong competitive position and an increasingly diverse business model, the company is extremely well placed to overcome temporary challenges to capitalise on a likely improvement in trading conditions over the long run. Other retailers may offer lower valuations at present, but on a risk/ reward basis there are few better investment opportunities within the sector than Next. Keep buying.

Questor says: buy

Ticker: NXT

Share price at close: £83.66

Read Questor’s rules of investment before you follow our tips: telegraph.co.uk/go/questorrules